Friday, July 17, 2009

Financials' earnings may look spectacular, but they are highly unstable

The market loves the two financial leaders: Goldman and JPMorgan. You hear stories about financials leading the US out of this recession. Watch out. What really drives earnings of the big NY financial firms is the trading and market making. With wide spreads, those who have the expertise, the balance sheet, and the securities/derivatives client coverage, have and will do well in the near term. But that constitutes a fraction of the financial services industry.

Even giants like Citi can not take advantage of this market for the following reasons:1. they have lost clients due to their shaky credit,2. they have no balance sheet to put to work given the massive "bad bank" portfolio they are trying to unwind,3. as a TARP bank there is no incentive for employees to generate extra revenue because they are not getting paid,4. as a semi-government agency they have become somewhat incompetent.

The situation gets even tougher once you look at banks who have no access to capital markets activities. Associated Banc-Corp is an example. From AP:

Shares of Associated Banc-Corp. fell 9.9 percent Friday, a day after the regional bank reported a loss as it increased its loan loss provision and recorded a one-time assessment paid to the Federal Deposit Insurance Corp.

Associated Banc-Corp said on Thursday it fell to a loss of $24.7 million for the second quarter as charge-offs for bad loans jumped.

In fact if you compare the S&P500 financials index with S&P500 regional banks index (see chart below), the discrepancy between these two types of firms emerges. Regional banks continue to struggle.

This divergence has implications even for financial market leaders in New York. It says that if spreads tighten or market making and securities sales activity slows down, even the leading firms will have a tough time. The performance Goldman and JPMorgan have shown the market represents earnings with highly volatile characteristics that are often difficult to replicate. Don't bet on the financial sector in this environment.

Disclosure: the author does not hold any positions in financial firms or indices.